Insurance is often described as a necessary evil. It can be expensive and, if you never need to claim, the premiums can feel like a waste of money. However, in many situations, most people agree that going without at least some cover is too risky.
I think most people want the same thing: to protect themselves and their family as cost-effectively as possible. Given the right information, most people will make a sensible decision. So, the challenge is knowing what types of cover you need and how much is enough. These decisions are not always intuitive, and it’s easy to overlook important considerations.
The goal of this blog is to help you assess your insurance cover and strike the right balance between managing risk and keeping premiums affordable.
Four products do different jobs
Life insurance pays a lump sum when you die, to whoever you have nominated. It is the simplest of the four products, and the one people usually think of first.
TPD insurance pays a lump sum if you become permanently unable to work, due to injury or illness. Unlike life insurance, you are still alive, so the financial hole it needs to fill is often larger, not smaller, because permanent incapacity combined with ongoing living costs is, in some respects, a worse financial outcome than death.
Income protection insurance replaces your income if you are temporarily or permanently unable to work due to illness or injury. It pays a monthly benefit rather than a lump sum, and insurers generally caps the amount you can insure at 70% of your income before tax. Of the four products, it generally offers the widest and most reliable protection, because it responds to a much broader range of situations.
Trauma insurance pays a lump sum on diagnosis of a specified medical condition – typically cancer, heart attack or stroke – regardless of whether you can still work. It is the most narrowly defined of the four products, and, in my view, the most optional. I will come back to why later.
This blog covers personal risk insurance only. Business insurance, including key person cover and buy/sell agreements, is a related but separate matter for business owners.
Own occupation or any occupation TPD: which one is right for you?
TPD policies define incapacity in one of two ways. An “own occupation” definition pays out if you can no longer perform your specific occupation, even if you could reasonably do other work. An “any occupation” definition pays out only if you cannot work in any occupation reasonably suited to your education, training or experience. Own occupation cover is more expensive and, since 1 July 2014, new cover has had to be held outside superannuation. This can increase the effective cost further because premiums paid personally are not tax deductible
We typically recommend any occupation TPD cover for most people, especially if they have good quality income protection. If you become permanently incapacitated, you are also likely to qualify for an income protection benefit, which compliments any TPD benefit. And I would rather direct premium dollars toward better income protection cover than pay up for a TPD definition that largely duplicates it.
Why more insurance can mean less wealth
More insurance provides greater protection, but it also means higher premiums and less surplus cash flow to invest. Investing less slows the growth of your asset base, which is one of the main factors that determines how much insurance you need.
As you accumulate assets, you become less dependent on your income to fund your family’s future. Your need for insurance therefore reduces and may eventually disappear altogether. However, spending too much on premiums can slow your progress towards that point. Every dollar spent on unnecessary cover is a dollar that could otherwise be invested towards financial independence.
This trade-off applies regardless of which asset classes you invest in. It comes down to how much of your surplus cash flow you direct towards protecting your financial position today, and how much you invest to reduce your need for insurance in the future.
There is no single correct balance, and the right mix will change as your circumstances evolve. That is why we assess insurance as part of a client’s long-term financial strategy and review it as their wealth grows.
Your insurance needs follow a lifecycle, not a straight line
How much cover you need is driven mostly by where you sit in your financial lifecycle. I think about it in four phases.
Young with few commitments. When you are young, before a partner, a mortgage or children, your financial and lifestyle commitments are minimal. Your insurance needs in this phase are genuinely low and basic.
High commitments, few assets. Once you have a partner, a home loan and young children, your commitments rise sharply while your net asset base is still relatively small. You are highly dependent on your ongoing ability to earn an income, and this is typically the highest insurance need of your life. The good news is that cover is relatively cheap in your 30s, so insuring fully during this phase is rarely cost prohibitive.
Transitional period. As your net worth and surplus cash flow grow through your 40s and 50s, your dependence on earning an income declines every year. This is the phase to proactively begin reducing cover, and it matters more than it sounds, because premiums begin to rise sharply as you get closer to 50. I have previously written about strategies to manage the cost of cover during this time.
Financial independence. Once you no longer need to work to fund your living expenses, your insurance needs arguably falls to zero. For many people, this arrives by their mid-50s.
Thinking in these terms changes the question you ask. Instead of “how much cover do I want,” the question in your 40s and 50s becomes “how quickly can I responsibly reduce cover to manage its cost.” People who go in without that framing tend to talk themselves into keeping their cover every single year, because each year of paying the premium makes it feel more essential, not less. Deciding on the wind-down at the outset, while you are still in your 30s, makes reducing cover later feel like the plan working, rather than added risk.
Stepped or level premiums? Why we favour one over the other
Premiums come in two structures. Stepped premiums increase every year as you age, tracking the rising cost of the underlying mortality and morbidity risk. Level premiums are set higher upfront so that, in theory, they stay flat for a set period, or for life.
Level premium marketing leans heavily on certainty – the promise that your premium will not rise. In practice, that promise is often weak. Level premiums are not guaranteed for life, and insurers can and have repriced entire back-books of level premium policies when a product line becomes unprofitable. Locking in today’s insurer at today’s price does not fully protect you from tomorrow’s repricing.
We prefer stepped premiums for two reasons, both of which follow from the approach outlined above.
First, as you build wealth through your 40s and 50s, your need for insurance should reduce. You may therefore reduce or cancel your cover before the later savings from level premiums have offset their higher upfront cost.
Second, stepped premiums provide greater flexibility. Level premiums do not lock you into an insurer, but paying more upfront creates an incentive to stay long enough to benefit from lower premiums later. With stepped premiums, you have less reason to maintain an existing policy to justify that earlier expense. You can reassess your cover and consider other insurers as your circumstances and the market change.
How we calculate the cover you may need
We adopted a two-step approach in calculating our recommended insurance cover.
Firstly, we calculate life and TPD insurance needs by estimating how much money a family would need today to fund its future expenses and financial commitments if a person died or became permanently incapacitated. We then subtract the assets available to meet those costs and the present value of any ongoing income. The remaining shortfall is the amount of insurance cover required.
On the liabilities side, we typically account for:
- Any debt you would want repaid, typically your home loan and enough investment debt to make any investment properties cash flow neutral.
- Enough to replace your contribution to your family’s ongoing living expenses, calculated as the present value of those contributions over your remaining life expectancy.
- Domestic help – we generally use $26,000 p.a. until your youngest child reaches age 15
- Education costs – school fees indexed at 3-5% p.a. through the high school years
- Funeral costs, around $20,000, relevant to the life insurance calculation only
- Nursing care, around $26,000 p.a. until life expectancy, relevant to the TPD calculation only, since this cost only arises if you are alive and incapacitated
- An emergency cash buffer, typically $20,000
On the assets side, we then subtract:
- Disposable assets and cash savings you would be willing to use
- Your superannuation balance, for the life calculation only. We generally exclude super from the TPD calculation, because a TPD benefit inside super is gated by the “permanent incapacity” condition of release under superannuation law, and the timing between an insurer paying a TPD claim and the fund being permitted to release it can create a genuine gap
- Your income protection benefit, if you have it, for the TPD calculation only, since an ongoing income stream reduces the lump sum otherwise needed
- Your partner’s income, if they would realistically continue working full-time
Every future dollar is converted to a present-day lump sum using a real discount rate, typically 4% p.a., reflecting a 7% investment return less 3% inflation.
As an illustration, a household with a $650,000 mortgage, two children aged four and six, $80,000 p.a. in living expenses and $40,000 in disposable savings can easily arrive at a life insurance need in the $1 million to $1.5 million range once family income replacement and education costs are added in, even before existing cover is considered.
We have built this exact methodology into a free calculator, which walks you through your own numbers line by line and shows the additional cover required for both life and TPD, for you and your partner.
Download the calculator at https://investopoly.com.au/
The final step, which is arguably just as important, is to assess whether the recommended cover is affordable relative to your income. Premiums should not materially compromise your ability to pursue your lifestyle and retirement goals, although some spending compromises may be necessary.
As a very general rule of thumb, we prefer to keep personal risk insurance premiums below 3% of gross annual income. We become particularly concerned when they exceed 5%.
How each type of insurance payout is taxed
A life insurance benefit paid through super as a lump sum is tax-free if the recipient qualifies as a dependant for tax purposes. This includes a spouse, a child under 18 or someone who was financially dependent on you.
A TPD benefit withdrawn from super as a lump sum is generally tax-free from age 60. Before age 60, the taxable component is generally taxed at up to 22%. If the disability tax concessions apply, a “tax-free uplift” increases the tax-free portion to reflect the working years lost due to disability.
Income protection benefits are taxed as ordinary income, just like your salary. However, PAYG tax is not always withheld before payment, so you may need to set aside money to cover the tax bill.
Trauma insurance benefits are generally tax-free.
Where you hold your cover matters
Once you know how much cover you need, the next decision is ownership: personal name, or inside superannuation. This varies by product.
We generally prefer life and TPD cover held inside superannuation, where the premium attracts a 15% tax deduction to the fund and cover tends to be cost-effective, though this depends heavily on which fund you are in. Older, larger super funds with a long claims history can carry costly insurance because of legacy claims experience baked into their pricing. Newer funds without that history such as Vanguard Super tend to price more competitively as a result, so its important to shop around.
Income protection is different. We typically prefer this held in personal names, because the premium is tax-deductible to you directly, which lowers the after-tax cost of the cover meaningfully compared with holding it inside super.
Trauma insurance has no alternative: it must be held personally, and the premium attracts no tax deduction either way. There is no structuring decision to make here, only the decision of whether to hold the cover at all, which I address below.
The fine print with income protection cover
Two important choices affect the cost of income protection: the waiting period and the benefit period. The waiting period is how long you must remain disabled before benefits begin to accrue – insurers pay benefits 30 days in arrears, so if your waiting period is, say, 60 days, you won’t receive your first benefit payment until 90 days after you become incapacitated. The benefit period is the maximum time benefits can continue while you remain eligible to claim.
We typically favour a 90-day waiting period. In our experience, this strikes a sensible balance between reducing premiums and how long you need to fund your expenses from savings or other resources such as sick and annual leave. We also generally favour a benefit period to age 65, so the policy can support you through most or all of your remaining working life.
Policy quality is just as important, particularly how the insurer defines disability. Good quality policies offer alternative tests based on your ability to perform important occupational duties, hours worked or the reduction in your income due to illness or injury. Meeting one of these tests may satisfy the disability definition. Where available, we generally favour this broader approach over a policy that relies on a single, more restrictive test. The precise definitions matter, including whether they change during a lengthy claim.
We also favour policies that are fully underwritten when you apply. This means the insurer assesses your health and other relevant circumstances before deciding whether to offer cover and on what terms. The process can be tedious and time consuming, involving medical questionnaires and, sometimes, blood tests or reports from your GP. However, it helps establish upfront how your medical history affects your cover. That is valuable information to have before you need to claim. It does not guarantee that every claim will be paid, but, in our view, a thorough assessment upfront can reduce the risk of unexpected coverage issues or disputes if you need to claim.
Trauma insurance: the most optional cover of the four
Trauma insurance pays a lump sum if you are diagnosed with a “specified condition”. Cancer is the most common cause of trauma claims.
If cancer or its treatment prevents you from working, you may also qualify for income protection benefits, subject to the waiting period. Therefore, there is some overlap in the financial protection these policies provide.
The main additional benefit of trauma cover is flexibility. The payout can allow you to take unpaid time off even if you are physically able to work or allow your partner to stop working temporarily to support you. It can also fund out-of-pocket medical expenses, including medicines that are not subsidised under the PBS.
If you already have a sufficiently large cash buffer, you may be comfortable self-insuring this risk, particularly if you also have good quality income protection. The question is whether using that buffer would materially compromise your other financial goals.
However, if trauma cover is relatively inexpensive for your age and health, you may still consider the additional protection worthwhile. As with all insurance, it comes back to balancing the benefit of the cover against its cost.
The events that should trigger an insurance review
Your insurance needs change as your life changes. Major events such as having a child, taking on a larger mortgage, a material change in income or wealth, or receiving an inheritance should prompt a review.
A review should consider the types and amounts of cover you hold, whether these should increase or decrease, and the after-tax premium cost. The balance between cost and protection can gradually shift, so a policy that represented good value several years ago may no longer do so.
My general advice is to ensure you are well insured when you are younger, have significant financial commitments and are still building wealth. This is often when your insurance needs are greatest and cover is relatively cheap.
Then, as your investment assets grow and your reliance on insurance reduces, consciously pare back your cover. This becomes particularly important as premiums rise.
